Credit Crunch

A Credit crunch is a situation when there is a sudden decrease in the availability of loans, caused by a serious increase in the bank’s interest rates – which are the main supplier of the loans. It is caused by a number of complicated reasons, like the bursting of the mortgage bubble, securitization, giving loans to unreliable people, or inaccurate credit ratings. I am going to discuss the reason which I consider to be the most important ones. I will also examine here the cures for the credit crunch and the impact that it has on the economy.

The most important reason for the credit crunch (also the current one in 2007/2008) is the fact that the banks were lending large amounts of money to clients who were not able to pay them back – the result of this is the financial losses of the lending institutions – the banks. In response to this situation, banks are increasing the interest rates and making it harder to get a loan. This causes a financial crisis –which we refer to as the credit crunch.

In America, banks used to buy other bank’s loans (which, as noted earlier, were loans given to unreliable people with little chance of paying back the money) as a cheaper form of borrowing. As the banks buy and sell from each other, those loans that many non-American lending institutions had bought, (those so called ‘sub prime’ credits, or securitization – selling the loans) – caused a situation where the banks would not lend money to other banks as they did not know how many of these ‘sub prime’ credits (mainly the mortgages given to people with bad ‘credit reputations’) those financial institutions have. When banks are not ready to lend money to each other, the liquidity (the movement of money) diminishes which causes a financial crisis.

This has a huge impact on the economy and causes panic on the financial market, increases food prices, causes bankruptcy in the major financial institutions (like the Lehman Brothers bank), and the dramatic outflow of cash from the stock.

The governments try to respond to those problems and decrease the losses caused by the crisis. The American government is lowering the federal funds to liquidate more capital. It is also regulating lending policies so that banks aren’t permitted to lend money to people with little chance of repaying it.

More importantly it also bails out the major financial institutions in financial trouble. It had to invest £700bn to purchase the risky credits from the banks and save them from bankruptcy.


Jan Beaupre